Analysis: Top fund managers were blindsided by U.S. bond market carnage

By Jennifer Ablan and Katya Wachtel and Tim McLaughlin

Published July 16, 2013

Reuters

The plunge in the U.S. Treasuries market in the past couple of months may well have been one of the most well-telegraphed reversals in financial market history.

Top money managers and investment strategists had warned the U.S. Federal Reserve was likely to soon begin paring back its bond-buying stimulus if U.S. economic data remained robust.

Bill Gross, who is known on Wall Street as "the Bond King," said on May 10 he believed "the 30-yr secular bull market in bonds" had likely ended at the end of April. Other leading Wall Street figures told the New York Fed they were concerned about the exposure of mom-and-pop investors in the event of a bonds slump.

And yet, when the market saw its swiftest rise in rates in a decade, many of those managers got caught napping, suffering big losses that hurt many institutions and individuals banking on steady returns from the bond market.

Interviews by Reuters with some of the biggest bond fund managers suggest that a misreading of the Fed, surprise at the speed of the sell-off, and in some cases over-confidence after years of gains, led to big reversals as the 10-year Treasury note climbed to a yield of 2.75 percent on July 8 from 1.63 percent in early May.

Some managers stayed in the same game too long, trying to squeeze the last gains out of a bond market rally that had produced great returns over the past seven years. Others said they had hedges in place against setbacks but the severity of the drop was so great the protection didn't work.

Dan Fuss, sometimes known as "the Buffett of Bonds" - after investment guru Warren Buffett - had been warning for some time of trouble ahead. And yet, the Loomis Sayles vice chairman bought bonds after yields rose in early May to levels he considered "cheap."

His timing couldn't have been worse. Shortly after, Fed Chairman Ben Bernanke started to discuss the way in which the Fed might reduce bond purchases in an address to lawmakers on May 22. The bond market began its meltdown.

"It was a tactical move to buy long-term Treasuries. Turns out not to be a real good idea," Fuss said about his Treasury purchases, saying he was blindsided by Bernanke's comments.

"In retrospect, we should have waited for the next sell-off but we did not know that bump was coming."

It was damaging but far from catastrophic for Fuss. His $23 billion Loomis Sayles Bond Fund is up 1.73 percent on the year. By comparison, the Barclays U.S. Government/Credit Bond index is down 2.55 percent and the benchmark Barclays U.S. Aggregate Bond Index is down 2.45 percent.

UNDERESTIMATED

Others fared worse. The average bond fund lost 3.3 percent in June, according to TrimTabs Investment Research. What started in May accelerated June 19, as Bernanke made Fed intentions to cut its $85 billion in monthly bond buying even clearer.

A $4.8 billion macro portfolio run by Brazilian bank BTG Pactual, one of 2012's best performing hedge funds, lost 2.18 percent in June, its first monthly loss in over a year. The fund said it cut credit exposure in mid-May but "nonetheless underestimated the scale and speed of the pull-back," according to a note to investors reviewed by Reuters.

The hedge fund managers who lost money last month blamed the swiftness of the market's dive for catching them off-guard. Low volatility in credit markets before the slide had made some of them over-confident and they had increased leverage as a result.

The magnitude of the move in Treasuries meant that some hedges on long positions in corporate and mortgage debt didn't work effectively, said Ray Nolte, co-managing partner and chief investment officer of SkyBridge Capital, an $8.2 billion fund of hedge funds, which invests in some credit-focused funds.

DoubleLine Funds Chief Executive Jeffrey Gundlach, who manages the $39 billion DoubleLine Total Return Bond Fund, had predicted the 10-year Treasury note yield would peak at 2.35 percent and end the year at 1.7 percent.

"I think it's a horrible time to be exiting bonds," he told clients in a webcast in early June. The DoubleLine fund is down a slight 0.52 percent this year, beating 95 percent of its peers.

But even as the sell-off took yields well above his target, Gundlach was clear with his investors in a follow-up call that he saw no reason to eat humble pie. He sees the rise in yields as only temporary and says his investors are far from panicking. "I personally received exactly one call from investors prior to my recent webcast," Gundlach told Reuters, describing that client as a "nervous nellie."

IGNORED THEIR OWN WARNINGS

In April, a group of money managers including hedge fund manager David Tepper of Appaloosa Management LP and Rick Rieder of BlackRock Inc, raised concerns at an informal discussion with New York Federal Reserve President William Dudley about the large inflow of dollars from mom-and-pop investors into fixed-income funds the past few years.

The minutes show these managers told Dudley and his team there are "risks associated with the potential reaction of retail investors to a sharp rise in rates."

But the large managers were as susceptible to the risks as any retail investor. BlackRock manages $3.8 trillion worldwide; its US Government Bond Fund lost 1.7 percent in June. Appaloosa's recent performance could not be immediately tracked.

Managers such as Gross, who is co-chief investment officer at Pacific Investment Management Co and manager of the world's largest mutual fund, have benefited from 30 years of steadily falling interest rates. But his fund, because of its immense size, was vulnerable to a sell-off because of the difficulty in nimbly shifting positions.

Pimco, which oversees more than $2 trillion in assets, saw its flagship $268 billion Pimco Total Return Fund suffer a record $9.6 billion in outflows in June. The fund is down 2.83 percent so far this year, ahead of only 25 percent of peers, according to Morningstar. The Pimco Total Return Fund added to its holdings of Treasuries and mortgage securities in June.

Gross said on Pimco's Twitter stream on July 7 that the one-to-two month performance figures "are a blip on a 40-year performance history." This past Sunday, he joked in reference to the return to shops of the American snack food, the Twinkie: "Gross: #Twinkies are back on Monday & bonds are too - with a longer shelf life than last April."

HOW BRAKE PADS CAN HELP

Not everyone was a loser.

Brinker Capital was among those who navigated the last several weeks without too much pain, and it can partly thank worn-out brake pads.

When the chief executive of an auto parts chain told the investment management firm that brake pads on U.S. cars were on average the oldest on record, the firm viewed it as a sign that the bunker mentality of the U.S. consumer had reached its limit.

"People driving around on worn-out brake pads illustrated, along with other data points, that the economy had to go in another direction, with a bias toward recovery," said Stuart Quint, a senior investment manager at Brinker, which runs $14.5 billion in funds from a Philadelphia suburb.

If that was the case, rates would have to rise. So the team put their money on the idea, trading in and out of the ProShares Short 20+ Year Treasury exchange-traded fund in the weeks before the meltdown. The $1.3 billion ETF uses leverage to bet against the U.S. Treasury bond market and is a favorite of short-term investors. Its $1 billion Crystal Strategy I fund had about 2 percent of its assets in the ETF at the end of June.

The bet paid off - the ETF gained 12 percent in the last three months, contributing to a 12 percent gain in Brinker's overall assets in the first half of 2013.

(Reporting by Jennifer Ablan and Katya Wachtel in New York, and Timothy McLaughlin in Boston; Editing by David Gaffen, Martin Howell and Tim Dobbyn)